Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 16/2015:
Firms’ risk endogenous to strategic management choices

Mantos D. Delis (), Iftekhar Hasan () and Efthymios G Tsionas ()

Abstract: Use of variability of profits and other accounting-based ratios in order to estimate a firm's risk of insolvency is a well-established concept in management and economics. This paper argues that these measures fail to approximate the true level of risk accurately because managers consider other strategic choices and goals when making risky decisions. Instead, we propose an econometric model that incorporates current and past strategic choices to estimate risk from the profit function. Specifically, we extend the well-established multiplicative error model to allow for the endogeneity of the uncertainty component. We demonstrate the power of the model using a large sample of U.S. banks, and show that our estimates predict the accelerated bank risk that led to the subprime crisis in 2007. Our measure of risk also predicts the probability of bank default both in the period of the default, but also well in advance of this default and before conventional measures of bank risk.

Keywords: risk; strategic management; endogenous; profit function; (follow links to similar papers)

JEL-Codes: C13; C33; E47; G21; G32; (follow links to similar papers)

45 pages, August 20, 2015

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This paper is forthcoming as:
Delis, Mantos D., Iftekhar Hasan and Efthymios G Tsionas, 'Firms’ risk endogenous to strategic management choices', British Journal of Management.

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